THE VALUATION OF THE COMPANY - BASE FOR ITS
CAPITALIZATION
Lukáš Hreus[1]
Abstract
Currently
the question of companies` capitalization is very frequent. According to the
condition of global economy it seems to be necessary change the gearing ratio
in lot of companies. There could be several ways how to do so and this paper
relies to those which are focused on increasing of equity. The calculation of
the company value is the base for capitalization of the firm by IPO. This
paperwork shows the model which could be used to estimate the market value in
time.
Introduction
The condition of
world economy steers the management of the company to think about the financial
health. The situation has fallen to panic state and lots of companies have to
face the problem how to finance their activities. Banks are in troubles and
this leads them to be more careful. This means that banks tend to change the
criteria for loan offering according the risk they undertake. It is
understandable because the funds the banks work with are very limited because
of lack of opportunities for banks to increase their funds. Banks do not trust
each other and it means that they are not willing to provide loans each other.
Therefore it is up to the companies and their management to convince the banks
about their creditability. It is the responsibility of the companies`
managements to boost the financial health of the firms. This can be achieved by
optimizing of the company’s risk profile. If the risk profile is favorable the
credit rating of the company is better and the loan’s conditions are friendly
as well. Firm’s creditability is the objective of the analysis and for this
reason creditability should be the primary objective of the management.
Effective creditors’ and debtors` management help the credit rating to grow up.
There are more possibilities for firms
to boost their creditability than the above. The gearing ratio is very popular.
Mostly banks in Czech Republic tend to lend money according the gearing ratio.
There are several ways how to make the gearing ratio more favorable. Companies
could repay a part of their debts, increase equity or use combination of both.
This paper is focused mostly on the equity. We do not take in consideration the
use of funds. It means that for this paper it is not important where the
company will invest the amount of money gained from change in gearing. We
assume that company need to raise its funds by increasing equity. According to
this it is necessary to calculate the value of the company to enable the
management to make a decision which way they should go. Without the value
estimation it is not possible to increase the equity by new issue of shares. It
would be useful to realize that there are two parties in this process and they
are just opposite. The management wants to issue and sell new shares for higher
price and on the other hand there are investors who want to buy the shares for
lower price. Both of them use their own models and methods but the real value
of the company is involved. Therefore the model for value estimation is very
useful to find the consensus in between these parties.
Goal and methodology
As it was mentioned in text above the
precious analysis is to be used in relation to financial management. But the
basic principle is to estimate the appropriate value of the assets in company.
The main goal of this paper is to construct such a model which could be able to
help both management and investors to make their decisions and its evolution in
time. There is no tool which would
be able to calculate exact value. Both parties are of different interests and
therefore they tend to use different methods. But actually the base for their
calculations is the same. The most important source for these models is coming
from accounting and reporting. First of all we need to assume that all relevant
financial data are available such as for example assets, liabilities, costs,
revenues and the net operating profit.
For the model it is essential to put
together several financial theories and fit them to the conditions to make them
work correctly. The first part of the system is to calculate the weighted
average costs of capital (WACC). The following formula represents the basic
method used in most of the books.
(1)
The equation (1)
represents the costs of capital in company where re is cost of
equity what means the interest rate which is expected by investors and rd
is interest paid for capital borrowed. Abbreviations E, D represent equities
and debts. To make this relation complete it is necessary to estimate the
interest rates. For costs of equities it would be useful to apply the basic
principles of CAPM theory.
(2)
The CAPM formula
(2) is quite general and need to be fitted to the situation according the data
available. The risk free rate (rf) could be estimated by interest
rate used for government bonds issues because investors find these instruments
as low risk investment. The market rate could be a problem to calculate.
According some theories this interest rate represents the expected capital
market gains. For further work we accept rm – rf as a
risk premium which relies on country rating grade. Also the beta coefficient
(β) is very complicated to calculate. This coefficient is the correlation
in between the company (industry) and the market (indices). Because of the fact
that it is difficult to fit up the beta coefficient for the undeveloped markets
(i.e. Czech Republic) it is useful to change the basic CAPM model to be
appropriate.
(3)
In the equation (3)
the beta coefficient is to be taken from high developed markets for example USA
where lots of companies are traded. In the relation above the rp represents
risk premium for the market. In this case these rps represent the Czech market
and the American market. When we add to the difference of Czech risk premium
and American risk premium the leverage of the company we are able to multiply
the beta coefficient and this coefficient is suitable for the certain market as
the relation between the company and the market index.
Afterwards
it is necessary to calculate the costs of debts where it is very important to
involve the taxation. Then the equation is:
(4)
where i
is interest rate and T is the effective tax rate valid for certain company.
By
using equations (1, 2, 3, 4) we are able to estimate the WACC for the company.
In this case the WACC is to be used as discount rate to the model of company
valuation. It means that the model will work with discounted cash flows of the
company. The process of calculation in the model is based on the two phases and
it is up to the human being what these periods are going to be. The basic
principle is that the first phase assumes the certain rate of company`s growth
and the second phase relies on the value of the last year from first phase
without further growth. That is because the estimation of growth after certain
period is becoming vague and therefore the final result should be too fuzzy and
could not be accepted. Therefore the equation is
(5)
To make
the relation above complete it is necessary to calculate the growth rate. This
could be done by several approaches, for instance according to Gordon’s growth
model, by relation between the ROE and retention ratio or by the relation
between the EVA and the GDP. For our model it is essential to find the EVA/GDP
relation and implement the results into the case. This could be done as
following
(6)
The
relationship between GDP and EVA do need some explanation. The accelerator rely
on real data but afterwards to estimate the growth rate it is necessary to
involve the predicted GDP which is easy to find in government economy reports.
Results
To test the model we have chosen the
company listed on Czech capital market and we assume that 3 year period is
appropriate to estimate the ratios needed. We used all financial statements
provided by the company within the period and implement the data into the
model. Also it is very important to mention that we decided to split the phases
as following, the first phase is represented by the 5 year period and the
second phase represents the rest without growth. The inputs are as following,
the beta coefficient from US market for the certain industry was 0,91, risk
free rate was estimated as 3,55 per cent and the risk premiums difference 5,84
per cent. According to (6) the predicted growth rate for the company was -3,16
per cent. Afterwards by using the (1) the weighted average costs of capital for
the company tested was 2,44 per cent and the starting level of cash flow was
approximately 855 million CZK.
|
Predicted
cash-flow |
|||||
|
1st
phase |
2nd phase |
||||
|
year + 1 |
year + 2 |
year + 3 |
year + 4 |
year + 5 |
year + 6 |
|
828 mio |
802 mio |
776 mio |
752 mio |
728 mio |
821 mio |
Tab. 1 – Company cash-flow prediction
according the phase
From the schedule 1
it is obvious that the prediction of the cash-flow for the company is in some
kind of downtrend what means that the cash-flow is sloping down. But in the
second phase there is a growth which is caused by expected growth rate. This
rate is expected by the company management and from the former talks it was
graded as real but not in the near future.
|
Total
value of the company |
|
|
Value from
the 1st phase |
3,6 mio |
|
Value from
the 2nd phase |
36,5 mio |
|
Operation
value |
40,1 mio |
|
Long term
debts |
9,7 mio |
|
Company
value |
30,4 mio |
|
Value per
share |
1697,67 CZK |
Tab. 2 – Company value & value per share
According to table
2 the value of the company is slightly more than 30 million CZK what means that
value per share should be approximately 1697 CZK. It was useful to compare the
result with the real market data. This data are announced by Prague Stock
Exchange every day and it is very important to compare the data of the relevant
period. After the comparison we found out that our results are higher than
market prices. This could be explained by the sentiment of the market and it is
important to mention that during the testing the market sentiment was quite
bearish. This means that prices did tend to fall even the companies are
financially stable. I am sure that within the next test of the same company the
bigger differences would occur. It is because the since that time the downtrend
got much stronger and these differences could not be smoothed until the market
sentiment is involved.
Conclusion
The estimating of company`s value is
difficult process and lots of factors have impact on this process. This paper
shows one of the possible ways how to do so but it is crucial to realize that
there is no such a model which is the perfect one. Lots of aspects need to be
considered. For example market trends, there are up and downtrends which
represent the sentiment of the market and are based mostly on psychology and
there is no exact science tool to describe the sentiment. Also the fundamentals
of markets are essentials. Mostly when there is a need of recapitalization of
the company. The bigger parts of these fundamental events are like a boom and
lots of them cannot be predicted perfectly. There is an option to predict these
fundamentals with a certain level of probability. This fact makes the model
vague but anyway by using appropriate statistical tools this vagueness could be
smoothed. For instance one of the possible solutions is to use statistical
spreads which could cope with some fundamental news. But we have to stess that
these spreads are up to individuals.
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